What is Alpha and Beta in Mutual Funds? | How it is Calculated?

Mutual funds have become integral to modern investment strategies, offering investors a diversified and professionally managed approach to wealth creation. When evaluating mutual funds, alpha and beta are the key factors which provide valuable insights into a fund's risk and return profile.

Understanding alpha and beta is crucial for making informed investment decisions. Alpha provides a measure of a fund's risk-adjusted performance, indicating whether its excess returns commensurate with the risk it takes. Beta, on the other hand, helps investors assess their risk tolerance and choose funds that align with their investment objectives.

Alpha: Measuring a Fund's Excess Returns

Alpha measures how much a mutual fund has outperformed or underperformed its benchmark index after adjusting for market risk. A positive alpha means that the fund has delivered higher returns than expected, on the other hand, a negative alpha implies underperformance.

Alpha Formula

Alpha = Fund Return – [Risk-Free Rate + Beta × (Benchmark Return – Risk-Free Rate)]

Suppose a mutual fund has a return of 14%, the risk-free rate is 6%, the benchmark return is 10%, and the fund’s beta is 1.1.

Alpha = 14 – [6 + 1.1 × (10 – 6)]

Alpha = 14 – [6 + 4.4] = 14 – 10.4 = 3.6

So, the fund’s alpha is 3.6, which means a good performance over its benchmark.

Beta: Quantifying a Fund's Volatility

Beta measures a mutual fund’s volatility compared to the market. A beta above 1 means the fund is more volatile than the market; below 1 means less volatile.

Beta Formula

Beta = (Fund Return – Risk-Free Rate) ÷ (Benchmark Return – Risk-Free Rate)

This formula is based on the CAPM (Capital Asset Pricing Model) equation.

Fund Return = Risk-Free Rate + Beta × (Benchmark Return – Risk-Free Rate)

If the fund return is 15%, the risk-free rate is 5%, and the benchmark return is 10%:

Beta = (15 – 5) ÷ (10 – 5) = 10 ÷ 5 = 2

So, the fund’s beta is 2, which means it is twice as volatile as the market.

How is Risk Measured?

In mutual funds, risk refers to the possibility of losing money or earning less than expected. It’s a key factor when choosing the right investment, especially for Indian investors who often prefer safer options. Mutual fund risk is measured in different ways, but two common indicators are standard deviation and beta.

Standard deviation shows how much a fund’s returns vary from its average return. A high standard deviation means the fund is more volatile and riskier, while a low value indicates more stable performance.

Beta, on the other hand, compares the fund’s movements with a market index like Nifty or Sensex. If the beta is 1, the fund moves exactly with the market. A beta above 1 means more ups and downs than the market, while below 1 means less.

Understanding risk helps you choose a fund that suits your comfort level. If you prefer stability, go for funds with lower beta and standard deviation. If you can handle more ups and downs for possibly higher gains, you may consider funds with higher risk levels.

How Are Risk-Adjusted Returns Measured?

Risk-adjusted returns tell you how much return a mutual fund gives for the amount of risk you’re taking. Just knowing how much a fund earned is not enough. You also need to know whether it gives better returns compared to the risk involved. These measures help compare funds more fairly.

When you invest in a mutual fund, you're not just looking for high returns—you also want to know if those returns are worth the risk you’re taking. That’s where the Sharpe Ratio becomes important. It helps measure how well a fund performs after adjusting for the level of risk involved.

The Sharpe Ratio shows how much extra return a fund is giving for every unit of risk taken. A higher Sharpe Ratio means the fund is doing a good job of giving better returns without taking too much risk. A lower ratio means the returns may not be worth the risk.

Sharpe Ratio = (Fund Return – Risk-Free Rate) ÷ Standard Deviation

where,

• Fund Return is how much the fund earned

• Risk-Free Rate is usually the return from a safe investment like a government bond

• Standard Deviation measures the ups and downs (volatility) in the fund’s returns

For example, if a mutual fund gives 12% return, the risk-free rate is 6%, and the standard deviation is 2, then:

Sharpe Ratio = (12 – 6) ÷ 2 = 3

A Sharpe Ratio of 3 is considered excellent. It means the fund is managing risk very well while delivering strong returns.

Why Are Alpha and Beta Ratios Important?

Both of these are important tools, using which you can know how well a mutual fund is performing and how risky it is. They help investors make better, more informed decisions.

Alpha tells you whether the fund manager has done a good job. A positive alpha means the fund has earned more than expected when compared to its benchmark. For example, if a large-cap fund earns more than the Nifty 50 index, it shows the fund manager added value. A negative alpha means underperformance.

Beta shows how much the fund's value goes up or down with the market. A beta of 1 means the fund moves in line with the market. A beta more than 1 means it’s more volatile.

When used together, Alpha and Beta give a full picture of how well your money is being managed.

Calculation of Alpha and Beta Ratios in Mutual Funds

To calculate Alpha and Beta in mutual funds, we use formulas from the Capital Asset Pricing Model (CAPM). These help understand both the performance and risk level of a fund.

Formula for Alpha:

Alpha = Fund Return – [Risk-Free Rate + Beta × (Benchmark Return – Risk-Free Rate)]

It shows the extra return a fund has given over what was expected. A positive alpha means good performance, while a negative alpha shows underperformance.

Example:

If Fund Return = 14%, Risk-Free Rate = 6%, Benchmark Return = 10%, and Beta = 1.1,

Alpha = 14 – [6 + 1.1 × (10 – 6)] = 14 – 10.4 = 3.6

So, the fund outperformed by 3.6%.

Formula for Beta:

Beta = (Fund Return – Risk-Free Rate) ÷ (Benchmark Return – Risk-Free Rate)

It shows how much the fund moves in response to the market.

Example:

If Fund Return = 15%, Risk-Free Rate = 5%, Benchmark Return = 10%,

Beta = (15 – 5) ÷ (10 – 5) = 10 ÷ 5 = 2

This means the fund is twice as volatile as the market.

These formulas help investors evaluate if a mutual fund suits their risk level and return expectations.

The Interplay of Alpha and Beta in Mutual Fund Evaluation

Alpha and beta, while distinct measures, play complementary roles in evaluating mutual fund performance. Alpha provides insights into a fund's ability to generate excess returns, while beta quantifies its sensitivity to market fluctuations. Together, they offer a comprehensive understanding of a fund's risk-return profile.

The interplay of alpha and beta is particularly crucial when evaluating funds with positive alphas. A high alpha does not necessarily imply that the fund manager has superior skills. The fund's outperformance may be due to its higher beta, meaning it takes on more risk to achieve those higher returns.

To assess whether a fund's outperformance is attributable to skill or risk, investors should consider the Sharpe ratio, a measure of risk-adjusted returns. The Sharpe ratio compares a fund's excess return over the risk free rate to its standard deviation, which measures its volatility. A higher Sharpe ratio indicates that the fund is generating superior returns relative to the risk it takes.

Practical Applications of Alpha and Beta

Alpha and beta can be used in various practical ways to evaluate mutual funds and make informed investment decisions. Here are some specific examples:

• Comparing funds: Investors can compare the alpha and beta values of different funds to identify those that have consistently outperformed their benchmarks while maintaining a level of volatility that aligns with their risk tolerance.
• Aligning investments with goals: By understanding the risk-return profiles of different funds, investors can choose funds compatible with their long-term investment objectives and risk tolerance.
  
• Assessing fund managers: Alpha can be used to assess the performance of fund managers and identify those who have consistently demonstrated the ability to generate excess returns.
  

Conclusion

Alpha and beta in mutual funds are essential metrics, providing valuable insights into a fund's risk-return profile. By understanding the interplay between these two measures, investors can make informed decisions about which funds align with their risk tolerance and investment goals. While alpha and beta provide valuable information, investors should also consider other factors, such as investment style, fees, and the overall market environment, when making investment choices.